Chapter 11 Essay

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N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich
CHAPTER

11

Aggregate Demand II:
Applying the IS-LM Model
© 2010 Worth Publishers, all rights reserved

SEVENTH EDITION

MACROECONOMICS

Context
 Chapter 9 introduced the model of aggregate demand and supply.

 Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve.

CHAPTER 11

Aggregate Demand II

2

In this chapter, you will learn:
 how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy  how to derive the aggregate demand curve from the IS-LM model

 several theories about what caused the
Great Depression

CHAPTER 11

Aggregate Demand II

3

Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market. r
LM

Y  C (Y  T )  I (r )  G
The LM curve represents money market equilibrium.

r1

M P  L(r ,Y )
Y1
The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets.
CHAPTER 11

Aggregate Demand II

IS
Y

4

Policy analysis with the IS -LM model
Y  C (Y  T )  I (r )  G

r
LM

M P  L(r ,Y )

We can use the IS-LM model to analyze the r1 effects of
fiscal policy: G and/or T
monetary policy: M

CHAPTER 11

Aggregate Demand II

IS
Y1

Y

5

An increase in government purchases 1. IS curve shifts right
1
by
G
1 MPC causing output & income to rise.
2. This raises money demand, causing the interest rate to rise…

r
LM

2.

r2 r1 3. …which reduces investment, so the final increase in Y
1
is smaller than
G
1 MPC
CHAPTER 11

Aggregate Demand II

1.

IS2
IS1

Y1 Y2

Y

3.

6

A tax cut
Consumers save r (1MPC) of the tax cut, so the initial boost in spending is smaller for T r than for an equal G…
2.
r21 and the IS curve shifts by
1.

LM

1.

MPC
T
1 MPC

2. …so the effects on r

and Y are smaller for T than for an equal G.

CHAPTER 11

Aggregate Demand II

IS2

IS1
Y1 Y2

Y

2.

7

Monetary policy: An increase in M
1. M > 0 shifts the LM curve down
(or to the right)
2. …causing the interest rate to fall
3. …which increases investment, causing output & income to rise. CHAPTER 11

Aggregate Demand II

r

LM1
LM2

r1 r2 IS
Y1 Y2

Y

8

Interaction between monetary & fiscal policy
 Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.

 Real world:
Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.

 Such interaction may alter the impact of the original policy change.
CHAPTER 11

Aggregate Demand II

9

The Fed’s response to G > 0

 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant

 In each case, the effects of the G are different…

CHAPTER 11

Aggregate Demand II

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Response 1:

Hold M constant

If Congress raises G, the IS curve shifts right.

r
LM
1

If Fed holds M constant, then LM curve doesn’t shift. r2 r1 IS2
IS1

Results:

Y  Y2  Y1

Y1 Y2

Y

r  r2  r1
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Aggregate Demand II

11

Response 2:

Hold r constant

If Congress raises G, the IS curve shifts right.

r
LM
1

To keep r constant,
Fed increases M to shift LM curve right.

2

r2 r1 IS2
IS1

Results:

Y  Y3  Y1

LM

Y1 Y2 Y3

Y

r  0
CHAPTER 11

Aggregate Demand II

12

Response 3:

Hold Y constant

If Congress raises G, the IS curve shifts right.
To keep Y constant,
Fed reduces M to shift LM curve left.

LM
2
LM

r

1

r3 r2 r1

IS2
IS1

Results:

Y  0

Y1 Y2

Y

r  r3  r1
CHAPTER 11

Aggregate Demand II

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Estimates of fiscal policy multipliers from the DRI macroeconometric model

Assumption about monetary policy

Estimated value of
Y / G

Estimated value of
Y / T

Fed holds money supply constant

0.60

0.26

Fed holds nominal interest rate constant

1.93

1.19

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Aggregate Demand II

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Shocks in the IS -LM model
IS shocks: exogenous changes in the demand for goods & services.
Examples:
 stock market boom or crash
 change in households’ wealth
 C
 change in business…